Why not?

The Governor’s press release this morning, leaving the OCR unchanged, was no surprise.

But it continues to seem out of step with the data, and with his responsibilities under the Policy Targets Agreement. The statement has the feel of being written by someone who really really does not want to cut the OCR, but who won’t explain why.  It is if the current level of the OCR were being treated as an end in itself, or being held up in pursuit of some other goal, rather than being a tool for influencing the (rather too low) medium-term rate of inflation.

Fortunately, the statement corrects what must have been a mis-step in John McDermott’s speech last week.  Today the Governor states that:

It would be appropriate to lower the OCR if demand weakens, and wage and price-setting outcomes settle at levels lower than is consistent with the inflation target.

Last week, that criterion was expressed in terms of lower than the “target range”.

But there is no reference anywhere in the statement to the 2 per cent midpoint, even though the Governor and the Minister explicitly agreed that the midpoint should be the Bank’s focus.  And wage and price-setting outcomes are already inconsistent with the target midpoint and have been now for some years.  This statement offers no tangible basis for expecting that to change, just the limp observation that underlying inflation “is expected to pick-up gradually”.  Why?  When?  What is about to change that will now reverse a slide in core inflation that has been underway, more or less continuously, since 2007?  It has to be something more than just a belief that monetary policy is “stimulatory”.

Once again, the Governor anguishes about the exchange rate.  I agree totally with the substance of his references to New Zealand’s long-term economic fundamentals and how out of step the exchange rate is with them (it was the heart of this paper I wrote for the Treasury-Reserve Bank forum on exchange rate issues in 2013).  But……this is a press release about the nominal OCR, not about the real factors that shape New Zealand’s longer-term competitiveness.  And while the Governor observes that “the appreciation in the exchange rate, while our key export prices have been falling, has been unwelcome”, he seems unwilling to take the obvious step in response.  Exchange rates are largely influenced by expected relative risk-adjusted returns, broadly defined.  When New Zealand interest rates have been rising while those in most of the rest of the world have been falling, and we have a Governor who appears very reluctant to cut those interest rates, it is hardly surprising that we end up with a cyclically strong exchange rate.  Cutting the OCR won’t solve the long-term economic challenges:  they are about real factors, not monetary policy. But a strong sense from the Bank that the OCR was heading back towards 2.5 per cent over the coming year, or perhaps even lower, would be likely to make a useful difference.

And why not do so?  Core inflation is very low, the number of people unemployed (and underemployed) lingers uncomfortably high, inflation expectations are falling, farm incomes are falling, credit growth is pretty modest, and so on.  So why not cut?    Of course, no one can be totally certain that, with hindsight, cuts will prove to have been the right policy, but on the New Zealand and global data as they stand today –  and without a compelling case to suggest the inflation picture is about to change materially –  not doing so increasingly looks negligent.  In time, it is the sort of stance that also risks further undermining public and political support for the broad monetary policy framework, and the Governor of the Bank’s powerful position within it.

The Bank’s take on the rest of the world, as reflected in the press release, is both puzzling and disconcerting.  The Governor reiterates what appears to be one of his favourite lines, that trading partner growth is around its long-term average.  This is true, but largely irrelevant.  First, it simply reflects the fact that China is a more important trading partner than it was, and its growth rates are higher than those in our other trading partners.  But even China is slowing, probably quite sharply.  And commodity prices –  a key way the rest of the world’s economy affects New Zealand –  have fallen a lot.

In addition, in almost all of our trading partners – and in most countries that are not our trading partners –  GDP remains well below pre-crisis trend levels. Not all of that is excess capacity, but a significant proportion is likely to be.  Again, the Governor makes much of the low interest rates abroad, but seems not to put much weight on why those rates are so low.  There are all sorts of idiosyncratic factors in individual countries, but across the world interest rates are low and falling not because central banks have arbitrarily put them there (it isn’t some “monetary policy shock” in the jargon), but because markets and central banks both judge that underlying demand and inflation pressures require interest rates be at least as low as they are.  That is a very worrying perspective on the world, not a comforting one.

Finally, the Reserve Bank likes to claim that it is highly transparent, citing for example its scores in papers like this one.  But in many of the more transparent central bank we could look forward to the minutes of the meetings that led to the decision being published. In some central banks, even the range of views is extensively outlined.  The Governor has noted he now makes his OCR decision in the so-called Governing Committee, with his three senior colleagues.  But we do not have access to the minutes of these meetings, even with a lag, or to a summary of the advice provided to the Governor by his wider group of advisers, including the external advisers.  Transparency and open government are not just about announcing and explaining final decisions, but about the process whereby those decisions were reached.  Some other New Zealand government agencies are quite good at pro-active release of background material (for example, papers leading up to the Budget).  It is a model the Reserve Bank could look at emulating.  In the next few days, I am expecting a response from the Reserve Bank to my OIA request for background papers to an OCR decision from 10 years ago.  It will be interesting to see how they interpret the Act is deciding how to respond.

11 thoughts on “Why not?

  1. Hi Michael,

    I agree with the general thrust of your note. Indeed your sentiments are almost identical to those I gave TWO years ago… (see OCR unsuited to quelling property price inflation, on Stuff, 7 May 2013)

    Why is the Bank so hawkish?

    My feeling is that there are two reasons: i) the econometric model is calibrated on data with a heavy pre-crisis bias so the parameter estimates are wrong – that’ll take time to settle down, and ii) I think the Governor has a fixation about Auckland property (despite clear evidence that there’s almost no price pressure nation-wide and minimal spill-over to other centers).

    What concerns me going forward is that our ‘rock star’ economy is built on a bust dairy sector, a 40bn rebuild in Christchurch that may start disappointing as we move more into commercial rebuild (anecdotal evidence here is weak) and an unsustainable rise in Auckland property. What happens when these dynamics (inevitably) stall?

    On the currency, the time for talk is passing – if the rbnz is determined to bring NzD down it must act…

    Drop me a line some time. In Wellington next Wednesday…

    Peter Redward


    • “[T]he econometric model is calibrated on data with a heavy pre-crisis bias so the parameter estimates are wrong – that’ll take time to settle down”.

      That is interesting – I was about to ask Michael a question along the same lines. I wonder if there is another model out there that is better calibrated to post-2000 and post-GFC data.


      • Blair

        I’m not sure I’d fully accept Peter’s description. One can think of a conventional Phillips curve in which inflation is determined by inflation expectations and the output gap (the latter times some coefficient to capture the relationship between the output gap and inflation). Neither inflation expectations nor the output gap are directly observable. We have a few surveys of inflation expectation but little direct evidence of what view on inflation people actually use to shape their econ behaviour (borrowing, wage negotiations, price-setting). The Bank has tended to use the 2 year ahead survey measure as a reasonable proxy, but no one really knows. The market in inflation-indexed instruments etc is much thinner here than in many advanced economies so that less information on inflation expectations is available from that source – and even if such info were available there would be questions about whether implicit market expectations were the same as those of ordinary firms and households.

        Measuring the output gap is even more problematic. The Bank’s standard technique was illustrated in a nice recent Analytical Note (I edited it, so made sure it was comprehensible to a not highly technical person like me). It prob works relatively well for conventional mild recessions and booms, but I think one should have much less confidence when – as now – GDP doesn’t appear just to be returning to trend but is some 14% below pre-recession trend. There is no easy way of knowing how much of that gap is a loss of potential, and how much is excess capacity. I’ve argued for some time that more weight should be put on the unemployment rate (and its deviation from trend) as an indicator of excess capacity – since labour market regulation and things that might affect the NAIRU don’t seem to have changed much recently, but there is always the risk of just latching onto the indicator that suits one’s story.

        One can simply assume the Phillips curve coefficient hasn’t changed and back out an implicit output gap consistent with the inflation outcomes we observe. I don’t find the results that implausible – an output gap of perhaps 1-2% negative, and falling inflation expectations could probably explain core inflation at around current levels. But it is a test of a joint hypothesis: maybe in fact the Phillips curve coefficient has changed and the responsiveness of inflation to excess capacity is greater than we thought. But in other countries, if anything, the presumptive interpretation was the other way round: for such a large negative output gap as the US ran up in the recession, how come inflation did not fall further.

        I don’t think there is any one superior formal model likely to help resolve the puzzles now. It will take time and more data – Peter’s point – and so the open issue is how the Bank should respond to what it does see when it looks out the window.


  2. Hi Michael,

    Don’t you think that what matters most for the economy is the natural rate of interest, or the average real interest rate rather [underline real]? The OCR is 3.5 percent, inflation average over 2014 was 1 percent, and the inflation target is 2 percent as you say. Given that we do not have inflation the output gap is either very small, zero, or maybe even negative. Thus, the average [real] interest rate is a 1 percentage point below the OCR. That’s my rough calculations. I reckon that you are saying, even though the average real interest rate is a lot lower than the OCR, the OCR should be reduced further. But the RB hinted that they would probably reduce the OCR if the new data show no wage inflation…The RB is probably uncertain about the forecast. They are cautious. But given that unemployment is still above the natural rate (my estimate and also others in NZ) and slowly falling, the RB should expect no increase in real wages…so in summary, given that there is no inflation around the world, and your assessment of the recovery (which I wrote about a blog a few months ago), your questioning of the policy stance is valid.

    Good to see Peter coming online.



  3. Weshah

    Natural real rates certainly matter a lot. But we are very uncertain – globally – where neutral rates are now. They can’t really be negative (in real terms), and they seem to have been trending down for some decades, but beyond that really who knows. That makes me uneasy about central banks talking in terms of monetary policy as a deviation from the natural rate (as the RB does when it calls current policy stimulatory). Conceptually it makes a lot of sense, but practically it might badly mislead. In what practical sense could we say that monetary policy is stimulatory – especially without identifying a continuing set of very powerful shocks that discretionary monetary policy is having to battle against.



  4. Is there not some other approach – whether one that includes an explicitly modeled banking system, or balance sheet effects – that accurately captures both the pre-2000 and post-GFC environments?

    On his recent interview on Econtalk, Scott Sumner said he thought that both the desired savings schedule had moved right and the investment schedule had moved down. (Desired savings were increased due to the rise of high saving East Asian economies, and the reduced desire for investment was due to demographics making investment less profitable). He thought these combined to make the equilibrium interest rate a lot lower. One thing he didn’t mention though, is the recursive aspect of the system. If the policy response of the central bank is to fall behind the curve, this will encourage more early retirement and for young people to stay in school in search of credentials, thus making the demographic problems worse, and the equilibrium interest rate even lower.


  5. Blair

    My slightly abrupt answer to your question is “no” – or at least not with any confidence. Seems to me everyone is casting around for a story to fit the facts as we now see them, pre and post 2007, and it is important that we do, but we really don’t have any good way of knowing which is the right story. That drives me to thinking there is little choice but to set today’s monetary policy using what we see out the window today. It wouldn’t be an optimal approach normally, but sometimes it is all one can sensibly do. That and prepare for the next severe downturn, whenever it comes, by getting pro-active about dealing with the ZLB constraint.



  6. Fwiw – I think today’s Q1 labour market data significantly strengthens the “why not” case as we look ahead to the next meeting…no decline in unemployment for nine months now, and no acceleration of wage growth…certainly dented my confidence that core inflation will pick up within an acceptable time period…I still worry about the impact on the housing market of a likely policy easing and whether this will come back to hurt us down the track, however.


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